What Is Pareto Analysis? How to Create a Pareto Chart and Example

What Is Pareto Analysis?

Pareto analysis is a technique used for business decision-making, but it also has applications in several different fields from welfare economics to quality control. It is based largely on the "80-20 rule." As a decision-making technique, Pareto analysis statistically separates a limited number of input factors—either desirable or undesirable—which have the greatest impact on an outcome.

Pareto analysis is premised on the idea that 80% of a project's benefit can be achieved by doing 20% of the work—or, conversely, 80% of problems can be traced to 20% of the causes. Pareto analysis is a powerful quality and decision-making tool. In the most general sense, it is a technique for getting the necessary facts needed for setting priorities.

Understanding Pareto Analysis

In 1906, Italian economist Vilfredo Pareto discovered that 80% of the land in Italy was owned by just 20% of the people in the country. He extended his research and determined that this disproportionate wealth distribution was the same across all of Europe. The 80-20 rule was formally defined as follows: The top 20% of a country’s population accounts for an estimated 80% of the country’s wealth or total income.

Joseph Juran, a Romanian-American business theorist, discovered Pareto’s research in 1937, approximately 40 years after it was published. Juran proceeded to rename the 80-20 rule as "Pareto’s Principle of Unequal Distribution."

Juran extended Pareto’s principle to the business world in order to understand whether the rule could be applied to problems faced by businesses. He observed that in quality control departments, most production defects resulted from a small percentage of the causes of all defects. So, by extension, 80% of the problems are caused by 20% of the defects; Juran's work implies that if you focus on fixing that 20%, you could have a big impact with minimal effort.

Modern-day applications of Pareto analysis are used to determine which issues cause the most problems within different departments, organizations, or sectors of a business. Hence, Pareto analysis is so important to save the most scarce resource in the business, which is time, in the area of solving problems.

Typically, Pareto analysis is employed by business managers, whose approach typically involves conducting a statistical analysis, such as a cause and effect analysis, to produce a list of potential problems and the outcomes of these problems. Following the information provided by the cause and effect analysis, the 80-20 rule can be applied. Here are some scenarios relevant to businesses where Pareto analysis might be applicable:

• Sharing information about defects/errors with high-priority stakeholders
• Prioritizing defects or tasks according to their severity, i.e. according to their impact on a system or business
• Analyzing data or errors/defects

Steps of Pareto Analysis

By applying the 80-20 rule, problems can be sorted based on whether they affect profits, customer complaints, technical issues, product defects, or delays and backlogs from missed deadlines. Each of these issues is given a rating based on the amount of revenue or sales and time lost, or the number of complaints received. Here is a basic breakdown of the steps of Pareto analysis:

1. Identify the problem or problems
2. List or identify the cause of the issues or problems, noting that there could be multiple causes
3. Score the problems by assigning a number to each one that prioritizes the problem based on the level of negative impact on the company
4. Organize the problems into groups, such as customer service or system issues
5. Develop and implement an action plan, focusing on the higher-scored problems first, in order to solve the problems

Not all problems will have a high score, and some smaller problems may not be worth pursuing initially. By allocating resources to high-impact issues or higher scores, companies can solve problems more efficiently by targeting the issues that have a major impact on profits, sales, or customers.

How to Create a Pareto Chart

A common part of Pareto analysis is to graphically depict the occurrence of each variable being tracked. This depiction is called a Pareto chart, and it organizes and displays information to show the relative importance of various problems or causes of problems. It is similar to a vertical bar graph in that it puts items in order (from the highest to the lowest) relative to some measurable effect of interest: frequency, cost, or time. Here is the process of making a Pareto chart.

1. Develop a list of problems to be compared.
2. Develop a standard measure for comparing the items. For example, how often it occurs: frequency (e.g., utilization, complications, errors); how long it takes (time); and how many resources it uses (cost).
3. Choose a timeframe for collecting the data.
4. For each item, tally how often it occurred (or cost or total time). Then, add these amounts to determine the grand total for all items.
5. Find the percent of each item in the grand total by taking the sum of the item, dividing it by the grand total, and multiplying by 100.
6. List the items being compared in decreasing order of the measure of comparison: e.g., the most frequent to the least frequent. The cumulative percent for an item is the sum of that item’s percent of the total and that of all the other items that come before it in the ordering by rank.
7. List the items on the horizontal axis of a graph from highest to lowest. Label the left vertical axis with the numbers (frequency, time, or cost).
8. Label the right vertical axis with the cumulative percentages (the cumulative total should equal 100%).
9. Draw in the bars for each item.
10. Draw a line graph of the cumulative percentages. The first point on the line graph should line up with the top of the first bar.
    

The final step is analysis. You can now analyze a Pareto chart by identifying those items that appear to account for most of the difficulty. In the example below, the Institute for Healthcare Improvement identified three vital types of errors discovered during surgical set-up.

Advantages and Disadvantages of Pareto Analysis

In the most general sense, the advantage of Pareto analysis is that it helps to identify and determine the root causes of defects or problems. It also helps to save time by focusing on the root causes of the problem at hand. In business, the most important resource is time. Due to time, the goals usually are not to eliminate or maximize but rather to optimize. And the Pareto rule helps with optimization. Hence, businesses can resolve defects or errors with the highest priority first.

Pareto charts can specifically help determine the cumulative impact of a problem. Cumulative impact results from effects caused by a problem happening over a long period of time. Pareto charts are especially useful for businesses or organizations because they can use them to plan the measures or actions that need to be taken in order to amend the problems. For this reason, Pareto charts can sharpen problem-solving and decision-making skills: problems related to a defect or error can be distilled into cohesive facts.

The main disadvantage of Pareto analysis is that it does not provide solutions to issues; it is only helpful for determining or identifying the root causes of a problem(s). In addition, Pareto analysis only focuses on past data. While information about past errors or problems is useful, it's not a guarantee that it will be relevant in future scenarios.

A final disadvantage of Pareto charts is that they can only show qualitative data that can be observed; they cannot be used to represent quantitative data. For example, Pareto charts cannot be used to calculate the mean, the standard deviation, or the average of the data, its variability, or changes in the measured attribute over time.

Example of Pareto Analysis

The Department of Ecology for the state of Washington performed a study to identify why oil spills happen. They gathered information on 209 oil spill incidents including internal peer review of the causes and potentially factored in input from responsible parties.

In total, the Department of Ecology identified dozens of causes for oil spills. It identified the primary causes as:

• Inattention/distraction (38 times cited)
• Procedural Error (31)
• Judgment (26)
• Mechanical Failure (23)
• Structural Failure (20)
• Unknown Causes (11)

The total number of explanations above (six) represents a little bit more than 20% of the total causes identified (29 total casual factors). However, these six causes cumulatively were responsible for 71% (149 of 209 cases) of oil spills identified. In this example of Pareto analysis, only a few data items are primarily responsible for most causes of oil spills.

Special Considerations

It's important to note that Pareto analysis does not provide solutions to issues, but only helps businesses to identify and narrow down the most significant causes of the majority of their problems. Once the causes have been identified, the company must then create strategies to address those problems.

Pareto analysis will typically show that a disproportionate improvement can be achieved by ranking various causes of a problem and by concentrating on those solutions or items with the largest impact. The basic premise is that not all inputs have the same or even proportional impact on a given output. This type of decision-making can be used in many fields of endeavor, from government policy to individual business decisions.

The Bottom Line

When there seem to be too many options to choose from or it is difficult to assess what is most important within a company, Pareto analysis attempts to identify the more crucial and impactful options. The analysis helps identify which tasks hold the most weight as opposed to which tasks have less of an impact. By leveraging Pareto analysis, a company can more efficiently and effectively approach its decision-making process.